How To Make A Trading Strategy

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How to make a profitable trading strategy more profitable?
Article in The Singapore Economic Review · September 2013

DOI: 10.1142/S0217590813500197
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The Singapore Economic Review, Vol. 58, No. 3 (2013) 1350019 (17 pages)
© World Scientific Publishing Company
DOI: 10.1142/S0217590813500197
HOW TO MAKE A PROFITABLE TRADING STRATEGY

MORE PROFITABLE?
TERENCE TAI-LEUNG CHONG*

Hong Kong Institute of Asia-Pacific Studies
by CHINESE UNIVERSITY OF HONG KONG on 06/22/15. For personal use only.
Shatin, N. T., Hong Kong

Singapore Econ. Rev. 2013.58. Downloaded from www.worldscientific.com
Department of International Economics and Trade

Nanjing University
Jiangsu, 210044, China
*chong2064@cuhk.edu.hk
TAU-HING LAM
Department of Economics
Shatin, N. T., Hong Kong
Published 28 August 2013
Chong and Lam and Chong et al. show that SETAR(200) and MA(50) outperform other rules in both
the U.S. and the Chinese stock market. This paper investigates the synergy of combining SETAR
(200) and MA(50) rules in ten U.S. and Chinese stock market indexes. It is found that the SETAR
rule performs better in the U.S. market, while the MA rule performs better in the Chinese market. In
addition, we find evidence that a new strategy combining the two rules together is able to create
synergy. An immediate implication of our result is that investors are able to improve the performance
of their portfolios by combining existing profitable trading rules.
Keywords: SETAR model; bootstrap; GARCH-M model; combined strategy; market efficiency.
JEL Classifications: C22, G10, G12
1. Introduction
The performance of technical trading strategies has long been examined in the literature.
For example, Fama and Blume (1966) and Jensen and Bennington (1970) show that filter
rules fail to outperform the buy-and-hold (B–H) strategy. Brock et al. (1992) show that the
moving average (MA) and the trading range break (TRB) rules can beat the B–H rule in the
Dow Jones index. Bessembinder and Chan (1995) show that technical trading rules are
profitable in the stock markets of Malaysia, Thailand and Taiwan. Hudson et al. (1996) and
Mills (1997) find that trading rules perform well in the FT30 index. Recently, there has
* Corresponding author.
1350019-1
The Singapore Economic Review
been growing interest in nonlinear trading rules (Fernández-Rodríguez et al., 2003;

Andrada-Félix et al., 2003; Nam et al., 2005; Pérez-Rodríguez et al., 2005). However,
most of the aforementioned studies focus on the performance of a given set of trading rules.
Chong and Lam (2010) show that SETAR(200) and MA(50) outperform other rules in the
U.S. market. Chong et al. (2012) conduct similar analysis for the Chinese markets and find
that most rules fail to produce significant returns, except for the SETAR(200) and MA(50)
models during the pre-SOE reform period. Based on the results of Chong and Lam (2010)
and Chong et al. (2012), this paper investigates the synergy of combining SETAR(200) and
MA(50) rules.1
Our sample consists of totally ten stock market indexes of the U.S. and China, including
the Dow Jones Industrial Average (DJIA), the NASDAQ Composite Index, the New York
Stock Exchange Composite Index (NYSE), the Standard and Poor’s 500 Index (S&P500),
the Shanghai A-share Index (SHA), the Shanghai B-share Index (SHB), the Shanghai
Composite Index (SHC), the Shenzhen A-share Index (SZA), the Shenzhen B-share Index
(SZB) and the Shenzhen Composite Index (SZC) in order to draw robust conclusions.
Compared to the U.S. market, the Chinese stock market has a much shorter history.
There are two stock exchanges in China. The Shanghai Stock Exchange and the Shenzhen
Stock Exchanges were launched on November 26, 1990 and April 11, 1991 respectively.
Two types of shares are traded, namely, A shares and B shares. Tradable A-shares are
available exclusively for local citizens and institutions. They are quoted in RMB and cannot
be traded by foreigners. The B shares could only be traded by foreign investors before 2001.
Since February 2001, local investors can also trade the B shares via legal foreign currency
accounts. The SHC index was launched on July 15, 1991. It consists of all stocks (A shares
and B shares) listed on the Shanghai Stock Exchange. The base day for the SHC index is
December 19, 1990 and the base value is 100. The SZC index began on April 3, 1991, with
a base price of 100. It is a market-capitalization weighted index of stocks in the Shenzhen
Stock Exchange which tracks the daily price movements of all the shares in the exchange.
The U.S. and Chinese stock markets are very different in terms of the size, stage of
development, market efficiency, institutional setting and the variety of stocks listed. As the
U.S. and China’s stock markets are respectively the largest developed and emerging stock
markets in the world, the result obtained in this paper has important implications on the
profitability of similar rules in other markets.
To mitigate our exposure to data-mining bias, our sample includes ten different stock-
market indexes. It is found that the SETAR(200) rule yields substantial returns in four major
U.S. and two Chinese B-share indexes. The MA(50) rule, on the other hand, is more profitable
in the Chinese market. We demonstrate, in almost all cases, that synergy can be achieved by
combining the MA and SETAR trading rules. An immediate implication is that investors can
improve the performance of their portfolios by combining the existing profitable trading rules.
The rest of this paper is organized as follows: Section 2 presents the methodology.
Section 3 discusses the data and reports the empirical results. Section 4 conducts a boot-
strap analysis. Section 5 explores the synergy of a combined rule and concludes the paper.
1 Other studies on combining technical trading rules include Fang and Xu (2003) and Lento (2009).
1350019-2
How to Make a Profitable Trading Strategy More Profitable?
2. Methodology
2.1. Self-exciting threshold autoregressive (SETAR) model
The self-exciting threshold autoregressive (SETAR) model was first proposed by Tong
(1978) and further elaborated by Tong and Lim (1980) and Tong (1983). Further exten-
sions of the model include Chen and Tsay (1993) and Astatkie et al. (1997). Recently,
Chong et al. (2008) apply the model to predict currency crises. Chong and Lam (2010)
show that trading rules based on the SETAR model are profitable in the U.S. stock market.
In this paper, we consider a simple two-regime first-order SETAR model for stock-index
returns:
ΔYt ¼ ðα0 þ α1 ΔYt1 ÞI½ ΔYtd ‚ γ þ ðβ0 þ β1 ΔYt1 ÞI½ ΔYtd < γ þ "t , ð1Þ
where Yt denotes the natural log value of the stock index at day t, γ represents the threshold
value, d is the lag length and I½A is an indicator function that equals 1 if condition A is
satisfied. We employ the recursive rolling technique to obtain the SETAR one-step-ahead
forecast.
The SETAR trading strategy is as follows:
Buy if Δ Y^ tþ1
w
> 0, ð2Þ
Sell if Δ Y^ tþ1 < 0,
w
ð3Þ
where w stands for the length of the observation window and Δ Y^ tþ1w
refers to the predicted
return that is based upon information from the most recent w observations. In short, if the
predicted price of the next trading day is higher than the price of today, we long the index,
otherwise we short it.
2.2. Moving average (MA)

The MA rule is the most widely investigated trading rule. A w-day MA is defined as:
Pw
P
MAt ðwÞ ¼ t¼1 t , ð4Þ
w
where Pt is the stock price at day t and w represents the bandwidth of the window. The MA
rule is also studied because of its popularity in the literature (Brock et al., 1992). The idea
behind computing MAs is to smooth out volatile series. When the stock price penetrates its
MA, a trend is considered to be initiated. In our case, let Yt ¼ Pt . According to the MA
rule, buy and sell signals are generated by the crossing of price and its MA, i.e.,
Buy if Yt > MAt ðwÞ, ð5Þ
Sell if Yt < MAt ðwÞ: ð6Þ
Therefore, if the price is higher than the MA, we long the index. Otherwise, we hold a short
position.
Chong and Lam (2010) and Chong et al. (2012) show that SETAR(200) and MA(50)
outperform other rules in the U.S. and the Chinese stock markets. In this paper, we will
focus on the SETAR(200) and MA(50) rules.
1350019-3
2.3. Test statistic

On each trading day, a trading signal will be generated and a position will be taken. The
daily conditional mean and variance of buy (sell) returns can be respectively written as
1 X
N
bðsÞ
bðsÞ ¼ ΔYtþ1 I t , ð7Þ
NbðsÞ t¼1
and
1 X
N
bðsÞ
2bðsÞ ¼ ð ΔYtþ1 bðs ÞÞ 2 I t , ð8Þ
NbðsÞ t¼1
where bðsÞ is the mean return of the buy (sell) period, 2bðsÞ refers to the conditional
variance of the buy (sell) signals, NbðsÞ represents the number of buy (sell) days, N is the
bðsÞ
number of observations of the sample, ΔYtþ1 is the one-day return and I t is an indicator
function which equals one if a buy (sell) signal is generated at time t, and equals zero
otherwise. The null and alternative hypotheses are respectively
H0 : bðsÞ ¼ , ð9Þ
H1 : bðsÞ 6¼ : ð10Þ
Following Brock et al. (1992), the t-ratio for the mean buy (sell) return is given as follows:
bðsÞ
tbðsÞ ¼ 2 , ð11Þ
ð NbðsÞ þ N2 Þ 1=2
where is the unconditional daily mean and 2 is the unconditional variance.

Next, we evaluate the significance of the buy–sell spread, which represents the return of
an average complete transaction. The null and alternative hypotheses are
H0 : b s ¼ 0, ð12Þ
H1 : b s 6¼ 0 ð13Þ
and the t-statistic can be expressed as follows:

tðbsÞ ¼ 2 b 2 s1=2 : ð14Þ
ð Nb þ Ns Þ
3. Data and Results

3.1. Data
Our data are obtained from DataStream. For comparison purposes, we use the same sample
period as Chong and Lam (2010) and Chong et al. (2012). The sample includes ten stock
market indexes, including 14,348 daily observations of the DJIA (Jan 1951 to Dec 2005),
8809 daily observations of the NASDAQ (Feb 1971 to Dec 2005), 10,436 daily obser-
vations of the NYSE (Dec 1965 to Dec 2005), 10,698 daily observations of the S&P500
(Dec 1964 to Dec 2005), 3652 daily observations of the SHA (Jan 1992 to Dec 2005),
1350019-4
3616 daily observations of the SHB (Feb 1992 to Dec 2005), 3913 daily observations of
the SHC (Jan 1991 to Dec 2005), 3455 daily observations of the SZA (Oct 1992 to Dec
2005), 3455 daily observations of the SZB (Oct 1992 to Dec 2005) and 3848 daily
observations of the SZC (Apr 1991 to Dec 2005). Table 1 reports the summary statistics of
the daily return of the aforementioned indexes. Note that the returns are leptokurtic and
skewed. For the Chinese stock market, the high standard deviation indicates its emerging
nature.
A significant serial correlation in stock returns is a sufficient condition for the existence
of trading rule profits. The autocorrelations and the Ljung–Box Q statistics are reported in
Table 1. Nine out of the ten indexes have the first-order autocorrelation larger than twice
the Bartlett asymptotic standard error band. All Ljung–Box Q statistics at the fifth lag are
statistically significant at the 1% level.

3.2. Results
Table 2 reports the estimation results of the SETAR model. The reason for choosing the
first-order SETAR model is due to its simplicity and predictability. Note that most of the
estimated coefficients are significant, suggesting that the first-order model is sufficient to
describe the dynamics of the return series.
Tables 3 and 4 report the performance of the two trading rules. Columns 2 and 3 of the
tables labeled with “N(Buy)” and “B(Sell)” show the number of buy and sell signals.
Columns 6, 7 and 10 marked with “Buy”, “Sell” and “Buy–Sell” show the daily condi-
tional mean for buy, sell and buy–sell returns. Columns 8 and 9 marked with “Buy > 0”
and “Sell > 0” are the fraction of buy and sell signals that produce positive returns. The
numbers in parentheses are the t-ratios for the hypotheses that the buy (sell) mean is
different from the unconditional mean and that the buy–sell spread is different from zero.
Both trading rules perform reasonably well in the U.S. market. For DJIA, the SETAR
(200) rule produces a buy–sell return of 0.136%. For NASDAQ and NYSE, the t-statistics
for the buy–sell return are significant. For S&P500, the SETAR trading rule produces a
significant buy–sell return of 0.1164%.
For China, except for SHA, where both the SETAR(200) and the MA(50) rules cannot
produce significant buy–sell returns, the performance of the two rules is good in all other
Chinese indexes. For example, all the buy–sell differences are positive and significantly
different from zero in a statistical sense for SHB. The SETAR(200) rule, in particular,
yields an extremely high buy–sell return of 0.4205%. For the SHC index, the MA(50) rule
yields a buy–sell return of 0.2125%. For the SZA index, both the SETAR(200) and the MA
(50) rules generate a significant buy–sell spread. The MA(50) rule produces a buy–sell
return of 0.1872%. For the SZB index, all the buy–sell spreads are significantly positive.
The SETAR(200) rule produces a buy–sell return of 0.3525%. For SZC, both the SETAR
(200) rule and the MA(50) rule are profitable. The MA(50) rule generates a high buy–sell
return of 0.2129%. Overall, the two trading rules perform well in the Chinese stock market.
The SETAR(200) rule performs better in B-share indexes, while the MA(50) rule performs
better in A-share and composite indexes.
1350019-5
Table 1. Summary Statistics for Daily Returns-Full Sample
DJIA NASDAQ NYSE S&P500 SHA SHB SHC SZA SZB SZC
Obs. 14348 8808 10435 10697 3651 3615 3912 3454 3454 3847
Mean 0.0003 0.0004 0.0003 0.0003 0.0004 0.0002 0.0006 0.0000 0.0001 0.0003
Std. 0.0090 0.0120 0.0088 0.0096 0.0283 0.0214 0.0263 0.0230 0.0216 0.0237
Skew 1.6988** 0.3120* 1.4806** 1.2869** 6.1692** 0.3939** 6.2791** 1.0565** 0.3751** 0.9361**
Kurtosis 51.768** 10.787** 37.231** 36.263** 145.97** 5.9399** 155.89** 19.617** 8.0799** 18.861**
JB stat 1609043** 42843** 606495** 589048** 3264553** 5408** 3986644** 56023** 9476** 57584**
(1) 0.0661 a 0.1016 a 0.1150 a 0.0530 a 0.0444 a 0.1629 a 0.0480 a 0.0129 0.1494 a 0.0324 a
(2) 0.0308 a 0.0118 0.0117 0.0190 0.0423 a 0.0054 0.0457 a 0.0340 0.0332 0.0253
(3) 0.0089 0.0131 0.0093 0.0188 0.0466 a 0.0444 a 0.0465 a 0.0238 0.0894 a 0.0459 a
1350019-6
(4) 0.0131 0.0352 a 0.0149 0.0212 a 0.0315 0.0179 0.0314 0.0711 a 0.0822 a 0.0557 a
(5) 0.0163 0.0025 0.0175 0.0092 0.0281 0.0029 0.0264 0.0115 0.0209 0.0283
Bar std. 0.0084 0.0107 0.0098 0.0097 0.0166 0.0166 0.0160 0.0170 0.0170 0.0161
Q (5) 83.866** 104.57** 145.87** 43.384** 28.156** 104.47** 32.268** 24.474** 133.45** 29.627**
Notes: Returns are calculated as the log difference of the stock index level. “JB stat” represents the Jarque–Bera test for normality. (i) is the estimated autocorrelation
at lag i. Q(5) is the Ljung–Box Q statistics at lag 5. “Bar std.” refers to the Bartlett asymptotic standard error band for autocorrelations. Autocorrelations greater than
twice the Bartlett asymptotic standard error band are marked with a . Numbers marked with *(**) are significant at the 5%(1%) level.
Table 2. Parameter Estimates for the SETAR Models
SETAR parameter estimates

ΔYt ¼ ðα0 þ α1 Δ Yt1 ÞI½Δ Ytd ‚ γ þ ðβ0 þ β1 ΔYt1 ÞI½ΔYtd <γ þ "t
α0 0.000241 0.000270 0.000725 0.000216 0.000129 0.000262 0.000314 0.004623 0.000072 0.000087
(3.0969)** (2.0697)* (2.3159)* (2.2285) (0.2707) (0.72558) (0.7309) (4.6316)** (0.1901) (0.2228)
α1 0.094023 0.182570 0.057540 0.079776 0.085265 0.193829 0.088146 0.104440 0.197521 0.093601
(9.0841)** (14.5109)** (2.4457)* (6.5100)** (4.8061)** (9.7471)** (5.1417)** (3.1853)** (10.9347)** (5.3435)**
β0 0.006099 0.000665 0.000178 0.004856 0.004485 0.022817 0.004071 0.000755 0.000286 0.004637
(9.3727)** (1.3782) (1.9949) (6.2922)** (2.1502) (5.1379)** (2.1669) (1.7851) (0.2195) (2.7338)*
1350019-7
β1 0.221305 0.086906 0.150467 0.176640 0.204829 0.298339 0.195622 0.050695 0.136618 0.275861
(7.9521)** (4.5301)** (14.1397)** (5.5182)** (4.6607)** (3.6059)** (4.6111)** (2.5606)* (3.0552)** (7.0912)**
γ 0.013417 0.015642 0.011406 0.013815 0.032851 0.032084 0.029832 0.015075 0.022859 0.031380
d 1 3 5 1 2 1 2 4 5 2
P-value 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
Notes: The SETAR models are estimated by OLS. We select the threshold and the lag that jointly give the smallest residual sum of squares. ΔYt is the continuously
compounded return on day t, d is the lag length and γ is the threshold value. Numbers in parentheses are t-statistics testing whether estimates are statistically different
from zero. “P-value” is the 500-simulation bootstrapped p-value testing the null hypothesis of no threshold effect. The bootstrap procedure is conducted in accordance
with Hansen (1997) under the assumption of homoscedastic errors. Numbers marked with *(**) are significant at the 5%(1%) level.
Table 3. Empirical Results for the SETAR(200) Rule
Data N(Buy) N(Sell) (Buy) (Sell) Buy Sell Buy > 0 Sell > 0 Buy–Sell
DJIA 9121 4973 0.008185 0.010392 0.000744 0.000616 0.52593 0.48824 0.001360
(3.9635)** (5.9017)** (8.5432)**
NASDAQ 5352 3202 0.010296 0.014387 0.001398 0.001423 0.61117 0.47314 0.002822
(5.0144)** (7.0540)** (10.4519)**
NYSE 6537 3646 0.007681 0.010488 0.000871 0.000790 0.53297 0.49589 0.001661
(4.2509)** (6.2384)** (9.0837)**
S&P500 6817 3616 0.008602 0.011402 0.000656 0.000509 0.48306 0.52848 0.001164
(2.6945)* (4.0716)** (5.8577)**
SHA 1567 1832 0.022226 0.024556 0.000359 0.000016 0.48054 0.51856 0.000375
(0.2740) (0.2623) (0.4641)
SHB 1328 2037 0.023281 0.019287 0.002466 0.001739 0.47515 0.47128 0.004205
(3.7258)** (2.8167)** (5.6651)**
1350019-8
SHC 1753 1906 0.029665 0.024597 0.001006 0.000179 0.49914 0.51994 0.001185
(0.7790) (0.7455) (1.3199)
SZA 1229 1976 0.024495 0.020125 0.001044 0.000591 0.50610 0.51721 0.001636
(1.3672) (1.0066) (2.0552)*
SZB 1457 1747 0.023896 0.019647 0.002119 0.001405 0.46946 0.49685 0.003525
(2.8061)* (2.4685)* (4.5683)**
SZC 1556 2041 0.023473 0.021886 0.001125 0.000430 0.49293 0.52131 0.001555
(1.2800) (1.0818) (2.0448)*
Notes: “N(Buy)” and “N(Sell)” are the number of buy and sell signals. “(buy)” and “(sell)” are the standard deviations of buy and sell periods. “Buy > 0”
and “Sell > 0” are the fractions of buy and sell returns greater than zero. Numbers in parentheses are t-ratios testing the significance of the mean buy return
from the unconditional mean, the mean sell return from the unconditional mean and the buy–sell spread from zero. Numbers marked with *(**) are significant
at the 5%(1%) level.
Table 4. Empirical Results for the MA(50) Trading Rule
DJIA 8630 5469 0.00755 0.01095 0.000393 0.000056 0.50927 0.52258 0.000338
(1.0575) (1.4400) (2.1635)*
NASDAQ 5231 3328 0.00954 0.01520 0.000985 0.000671 0.59128 0.51082 0.001657
(3.0322)** (4.1060)** (6.1828)**
NYSE 6276 3910 0.00735 0.01082 0.000421 0.000041 0.51291 0.53529 0.000380
(1.0313) (1.4025) (2.1074)*
S&P500 6296 4152 0.00806 0.01166 0.000296 0.000181 0.47173 0.57009 0.000115
(0.2931) (0.3932) (0.5947)
SHA 1586 1816 0.02347 0.02352 0.000783 0.000387 0.49748 0.50165 0.001171
(0.8688) (0.8053) (1.4496)
SHB 1493 1873 0.02236 0.01980 0.001826 0.001596 0.48426 0.46236 0.003422
(2.9043)** (2.5076)* (4.6865)**
1350019-9
SHC 1767 1896 0.02898 0.02526 0.001490 0.000636 0.51952 0.49578 0.002125
(1.3957) (1.3389) (2.3681)*
SZA 1454 1751 0.02220 0.02163 0.001058 0.000813 0.51444 0.50771 0.001872
(1.4708) (1.3094) (2.4075)*
SZB 1541 1664 0.02402 0.01929 0.001762 0.001258 0.47761 0.49099 0.003020
(2.3299)* (2.2048)* (3.9273)**
SZC 1678 1920 0.02291 0.02225 0.001380 0.000748 0.51251 0.50417 0.002129
(1.6964) (1.5598) (2.8197)**
Notes: “N(Buy)” and “N(Sell)” are the number of buy and sell signals. “(buy)” and “(sell)” are the standard deviations of buy and sell periods.
“Buy > 0” and “Sell > 0” are the fractions of buy and sell returns greater than zero. Numbers in parentheses are t-ratios testing the significance of the mean
buy return from the unconditional mean, the mean sell return from the unconditional mean and the buy–sell spread from zero. Numbers marked with *(**)
are significant at the 5%(1%) level.
4. Bootstrap Analysis
The significance of the trading-rule returns is also evaluated using the bootstrapped dis-
tributions generated from different null models. The bootstrap is conducted as follows:
First, residuals of models under the null hypothesis are drawn with replacement to generate
artificial returns and prices. The trading rules are then applied to the simulated series. The
means, standard deviations and t-statistics of the trading rule returns are recorded. The
procedure is repeated for 500 times to provide a good approximation of the estimators.
The proportion of the simulated values larger than those from the actual series gives the
bootstrapped p-value. We first bootstrap the random-walk model with drift:
ΔYt ¼ constant þ "t : ð15Þ
The random-walk specification is consistent with the Efficient Market Hypothesis

(EMH) that stock prices are not predictable. Apart from the random-walk model, we also
bootstrap the generalized autoregressive conditional heteroskedasticity in mean (GARCH-
M) model defined as follows:
ΔYt ¼ 0 þ 1 "t1 þ 2 ht þ "t , ð16Þ
ht ¼ η0 þ η1 " t1 þ η2 ht1 ,
2
ð17Þ
qffiffiffiffi
"t ¼ ht zt , ð18Þ
where zt Nð0, 1Þ and ht refers to the conditional variance, which is conditionally nor-
mally distributed.
The GARCH-M specification is also consistent with the EMH, where higher ex ante
expected returns are associated with higher conditional volatility. Therefore, the results of
the GARCH-M simulations allow us to distinguish whether trading-rule returns are due to
time varying risk-return equilibrium or market inefficiency.
Table 5 reports the estimation results of the GARCH-M model.
For the conditional variance equation, all the η1 and η2 estimates are significant. In
addition, eight series have a positive 2 estimate, implying that a higher expected return is
required to compensate for the increasing risk.
4.1. Random-walk model

The random-walk bootstrap results are reported in Tables 6 and 7.
The figures reported in the tables are the fractions of simulated values that are larger
than those derived from the actual observations. In Table 6, for the case of the U.S., our
conclusions are similar to those obtained from the conventional t-test. For the SETAR(200)
rule, the p-values are all zeros for buy–sell spreads and the simulated buy–sell t-statistics,
indicating that none of the simulated buy–sell spreads and the simulated buy–sell t-sta-
tistics of the SETAR rule is greater than those obtained from the four actual indexes. For
the MA(50) rule in Table 7, the p-values are also very small for the four U.S. indexes. As a
result, we conclude that the SETAR(200) and MA(50) rules are profitable in the U.S.
market. Observe from the values of standard deviations that the random-walk simulations
1350019-10
Table 5. Parameter Estimates for the GARCH-M Model

ΔYt ¼ 0 þ 1 "t1 þ 2 ht þ "t
ht ¼ η0 þ η1 " 2t1 þ η2 ht1
pffiffiffiffi
"t ¼ ht zt
zt Nð0, 1Þ
0 0.000145 0.000484 0.000149 0.000059 0.000333 0.001577 0.000087 0.000213 0.001640 0.000282
(1.5003) (4.0643)** (1.2216) (0.3280) (1.2402) (3.7811)** (0.3526) (0.6136) (3.7984)** (3.3333)**
1 0.105519 0.235868 0.144617 0.072865 0.059600 0.152303 0.014600 0.010405 0.146165 0.015169
(11.486)** (21.243)** (13.858)** (6.9667)** (3.1095)** (8.0817)** (0.8146) (0.5478) (7.4383)** (0.8315)
1350019-11
2 4.905549 2.768925 5.613399 5.003145 0.311700 3.061745 0.450200 1.220034 3.454249 1.208765
(3.4521)** (2.1517) (3.0404)** (2.1662) (0.9829) (2.6189)* (1.3631) (1.5540) (2.8534)* (2.5372)*
η0 0.000001 0.000001 0.000001 0.000002 0.000020 0.000022 0.000014 0.000002 0.000047 0.000005
(7.3325)** (7.8557)** (6.7780)** (4.7614)** (7.0097)** (7.3578)** (6.4135)** (3.4846)** (9.4552)** (4.1430)**
η1 0.065409 0.115950 0.074359 0.036530 0.318100 0.196695 0.297200 0.071103 0.267521 0.085945
(17.310)** (15.318)** (14.139)** (7.9108)** (12.469)** (12.115)** (11.948)** (11.364)** (10.773)** (12.285)**
η2 0.927098 0.875968 0.913356 0.939658 0.738400 0.768936 0.760400 0.931735 0.635973 0.913266
(216.94)** (115.67)** (144.65)** (98.850)** (39.113)** (44.494)** (40.245)** (167.41)** (22.942)** (120.31)**
Notes: The GARCH-M model is estimated using the maximum likelihood method. Δ Yt is the continuously compounded return and ht is the conditional variance. The
numbers in parentheses are t-ratios testing whether estimates are statistically different from zero. Numbers marked with *(**) are significant at the 5%(1%) level.
Table 6. Random-walk Bootstrap Simulation Tests for 500 Replications: SETAR(200)
Result Buy (Buy) t-stat(Buy) Sell (Sell) t-stat(Sell) Buy–Sell t-stat(Buy–Sell)
Fra > DJIA 0.0000 1.0000 0.0000 1.0000 0.0120 1.0000 0.0000 0.0000
Fra > NASDAQ 0.0000 1.0000 0.0000 1.0000 0.0000 1.0000 0.0000 0.0000
Fra > NYSE 0.0000 1.0000 0.0000 1.0000 0.0040 1.0000 0.0000 0.0000
Fra > S&P500 0.0000 1.0000 0.0000 1.0000 0.0040 1.0000 0.0000 0.0000
Fra > SHA 0.4720 0.9880 0.2700 0.7220 0.8160 0.7060 0.3120 0.2860
Fra > SHB 0.0220 0.0040 0.0560 0.5640 0.9980 0.8120 0.0860 0.0860
Fra > SZC 0.0340 0.5500 0.0140 0.9040 0.9180 0.9700 0.0200 0.0140
Fra > SZA 0.0220 0.1380 0.0060 0.8600 0.9860 0.9760 0.0160 0.0120
Fra > SZB 0.0000 0.0040 0.0000 1.0000 0.9900 1.0000 0.0000 0.0000
Fra > SZC
0.0340 0.5500 0.0140 0.9040 0.9180 0.9700 0.0200 0.0140

Notes: The random-walk series are generated using the scrambled returns. The rows marked with “Fra>” refer
to the fraction of simulated means, standard deviations and t-statistics that are larger than those from the actual
series.
fail to replicate the volatility of the two trading rules. The p-values in the “(buy)” and
“(sell)” columns demonstrate that the model overestimates (underestimates) the condi-
tional standard deviation of the buy (sell) returns.
For the Chinese market, the results are also consistent with the conventional t-test. For
SHA, the bootstrapped p-values in the “Buy–Sell” column are higher than 5%, implying
the failure of the trading rules. For the two B-share indexes, the p-values are close to zero,
indicating the presence of abnormal returns. Lastly, significant returns are obtained by the
MA(50) rule in the SHC index, and by the SETAR(200) and the MA(50) rules in the SZA
and the SZC indexes.
For the conditional standard deviations, the fractions in the columns of “(buy)” and the
“(sell)” suggest that the random-walk model is able to replicate the conditional variations
in A-share and Composite indexes. However, the p-values in the columns of “(buy)” and
Table 7. Random-walk Bootstrap Simulation Tests for 500 Replications: MA(50)
Fra > DJIA 0.0920 1.0000 0.0120 0.9720 0.0000 0.9940 0.0100 0.0100
Fra > NASDAQ 0.0000 1.0000 0.0000 1.0000 0.0000 1.0000 0.0000 0.0000
Fra > NYSE 0.0780 1.0000 0.0300 0.9400 0.0000 0.9840 0.0140 0.0200
Fra > S&P500 0.3400 1.0000 0.2580 0.2860 0.0000 0.7520 0.2520 0.2520
Fra > SHA 0.2580 0.9400 0.0680 0.8920 0.9220 0.9260 0.1000 0.0680
Fra > SHB 0.0000 0.0940 0.0000 1.0000 0.9940 1.0000 0.0000 0.0000
Fra > SHC 0.0680 0.2160 0.0080 0.9760 0.4640 0.9860 0.0040 0.0080
Fra > SZA 0.0280 0.6520 0.0060 0.9380 0.8500 0.9960 0.0060 0.0060
Fra > SZB 0.0000 0.0040 0.0000 1.0000 1.0000 1.0000 0.0000 0.0000
Fra > SZC 0.0160 0.6880 0.0020 0.9740 0.8720 0.9980 0.0020 0.0020
Notes: The random-walk series are generated using the scrambled returns. The rows marked with “Fra>” refer
to the fraction of simulated means, standard deviations and t-statistics that are larger than those from the actual
series.
1350019-12
Table 8. GARCH-M Bootstrap Simulation Tests for 500 Replications: SETAR(200)
Fra > DJIA 0.0140 1.0000 0.0000 1.0000 0.0020 1.0000 0.0000 0.0000
Fra > NASDAQ 0.9360 1.0000 0.9100 0.4380 0.0000 0.3580 0.8220 0.8200
Fra > NYSE 0.1760 1.0000 0.1420 0.9960 0.0020 0.9820 0.0320 0.0380
Fra > S&P500 0.1760 1.0000 0.1420 0.9960 0.0020 0.9820 0.0320 0.0380
Fra > SHA 0.7260 0.9940 0.5860 0.4880 0.8620 0.3740 0.6320 0.6120
Fra > SHB 0.0220 0.0040 0.0560 0.5640 0.9980 0.8120 0.0860 0.0860
Fra > SHC 0.1940 0.1400 0.0500 0.8780 0.5720 0.8740 0.0800 0.0860
Fra > SZA 0.0320 0.1320 0.0080 0.8840 0.9900 0.9660 0.0160 0.0140
Fra > SZB 0.1040 0.0140 0.1280 0.5740 0.9860 0.7580 0.1800 0.1720
Fra > SZC
0.0460 0.5100 0.0080 0.8560 0.9180 0.9600 0.0260 0.0180

Notes: The GARCH-M series are generated using estimated parameters and scrambled residuals. The rows
marked with “Fra> ” refer to the fraction of simulated means, standard deviations and t-statistics that are larger
than those from the actual series.
“(sell)” in B-share indexes demonstrate that the simulated standard deviations of buy
signals are smaller than those derived from the actual series, while the simulated standard
deviations of sell signals are higher than those generated from the actual series.
4.2. GARCH-M model

Tables 8 and 9 report the results of GARCH-M bootstrap simulations for the two trading
rules.
For the U.S. market, the small p-values obtained from the SETAR(200) rule in the
columns of “Buy–Sell” and the “t-stat(Buy–Sell)” imply that the rule yields a substantial
risk-adjusted return. For the conditional standard deviations, the p-values in the columns of
“(buy)” and the “(sell)” are 1.00 and 0.00 respectively, implying that the GARCH-M
simulations cannot replicate the conditional volatility.
Table 9. GARCH-M Bootstrap Simulation Tests for 500 Replications: MA(50)
Fra > DJIA 0.4340 1.0000 0.3840 0.6960 0.0000 0.7180 0.3160 0.3260
Fra > NASDAQ 0.0740 1.0000 0.0060 0.9980 0.0000 1.0000 0.0000 0.0000
Fra > NYSE 0.4380 1.0000 0.5060 0.5400 0.0000 0.6000 0.4360 0.4440
Fra > S&P500 0.6780 1.0000 0.7360 0.3140 0.0000 0.2920 0.7140 0.7180
Fra > SHA 0.1000 0.9600 0.0060 0.9680 0.9400 0.9940 0.0100 0.0060
Fra > SHB 0.0020 0.0980 0.0020 0.9600 0.9880 0.9980 0.0020 0.0020
Fra > SHC 0.0140 0.2360 0.0040 0.9900 0.4700 0.9980 0.0020 0.0040
Fra > SZA 0.0460 0.6760 0.0100 0.9280 0.8540 0.9880 0.0160 0.0100
Fra > SZA 0.0460 0.6760 0.0100 0.9280 0.8540 0.9880 0.0160 0.0100
Fra > SZC 0.0320 0.6780 0.0120 0.9460 0.8640 0.9920 0.0120 0.0100
Notes: The GARCH-M series are generated using estimated parameters and scrambled residuals. The rows
marked with “Fra>” refer to the fraction of simulated means, standard deviations and t-statistics that are larger
than those from the actual series.
1350019-13
For the Chinese market, except for the case of the SETAR(200) rule in SZA and SZC
indexes, all the simulated buy–sell returns and their t-ratios are generally higher than those
from the original series. For the MA(50) rule, the p-values in the columns of the buy–sell
mean and the buy–sell t-statistic are essentially zero for all indexes. The results for the
standard deviations are analogous to those in the random-walk simulations, suggesting that
the GARCH-M model can successfully replicate the return volatility of the two trading
rules in A-share and composite indexes. Therefore, our bootstrap results show that the two
rules perform quite well.
5. The Combined Strategy and Concluding Remarks

The success of the SETAR(200) and MA(50) trading rules sparks our interest to explore
the synergy of combining these two profitable trading rules. Combining the trading rules
generally reduces the risk and generates fewer noisy trading signals as compared to a single
rule. We define a combined strategy as follows:
Buy if SETAR : Δ Y^ tþ1
200
>0 and MA : Yt > MAt ð50Þ, ð19Þ
Sell if SETAR : Δ Y^ tþ1
200
<0 and MA : Yt < MAt ð50Þ: ð20Þ
The performance of the new strategy, as seen from Table 10, is encouraging.
Significant buy–sell returns are obtained in nine out of the ten indexes. In comparison to
Tables 3 and 4, the combined strategy results in fewer transactions and yields a higher
buy–sell return than the two individual rules. It outperforms the individual SETAR(200)
and MA(50) strategies in all the six China’s indexes and in three out of the four U.S.
indexes. For example, for the Shanghai B-share market, the buy–sell return of the SETAR
(200) rule is 0.4205%, while the buy–sell return of the MA(50) rule is 0.3422%. Both
are considered high returns but are still dominated by the combined-strategy return of
0.6083%. For the Shenzhen B-share market, the buy–sell return is 0.3525% for the SETAR
(200) rule alone, 0.302% for the MA(50) rule alone, but 0.5317% for the combined
strategy. For the Shenzhen B market, the return buy–sell is 0.3525% for the SETAR(200)
rule alone, 0.302% for the MA(50) rule alone, but 0.5317% for the combined strategy.
Even for the S&P500 case where the combined strategy does not dominate the two in-
dividual strategies, the return difference is not noticeable. The buy–sell return is 0.1164%
for the SETAR(200) rule alone, 0.0115% for the MA(50) rule alone, but 0.1157% for the
combined strategy. The combined strategy outperforms the SETAR(200) and MA(50)
strategies 90% of the time. Our results provide empirical evidence that a combined trading
strategy dominates pure trading strategies. A possible explanation is that a trade will not be
triggered by the combined rule unless both SETAR and MA conditions are satisfied, so
combining trading rules help to reduce the number of false signal and to increase profits.2
2 There should be an optimal number of individual rules to be included in the combined strategy. A problem with combining
many profitable strategies is that it is difficult for all conditions to hold in order to trigger a trade. The more conditions we
impose the more difficult for us to observe a trading signal. In the extreme, there may not be trading signal in all in the entire
sample period and we cannot compute the profits of the combined rule. Therefore, combining as many profitable trading rules
as possible is certainly not the way to maximize the combined profits.
1350019-14
Table 10. Empirical Results for the Combined Trading Strategy: SETAR(200) þ MA(50)
DJIA 6448 2793 0.00742 0.01196 0.000648 0.000817 0.74395 0.08879 0.001464 a
(2.8356)** (5.7715)** (7.1589)**
NASDAQ 3815 1788 0.00889 0.01658 0.001488 0.002259 0.85740 0.05649 0.003746 a
(4.8687)** (8.2775)** (10.817)**
NYSE 4668 2038 0.00693 0.01187 0.000702 0.001104 0.74636 0.09814 0.001806 a
(2.7311)** (6.4198)** (7.6857)**
S&P500 4742 2063 0.00794 0.01315 0.000489 0.000669 0.69443 0.17353 0.001157
(1.4071) (3.9490)** (4.5414)**
SHA 893 1140 0.02371 0.02534 0.000627 0.000618 0.84323 0.22632 0.001245 a
(0.5253) (0.9708) (1.1855)
SHB 800 1344 0.02400 0.01876 0.003505 0.002577 0.78875 0.19866 0.006083 a
(4.3252)** (3.6848)** (6.4723)**
1350019-15
SHC 1023 1165 0.03277 0.02567 0.002058 0.000745 0.85533 0.21459 0.002803 a
(1.7354) (1.2457) (2.4102)*
SZA 755 1277 0.02191 0.02417 0.001792 0.001061 0.82384 0.25294 0.002853 a
(1.9770)* (1.5175) (2.8360)**
SZB 905 1112 0.02502 0.01794 0.003534 0.001782 0.75580 0.21942 0.005317 a
(4.0839)** (2.6074)** (5.4609)**
SZC 935 1298 0.02402 0.02207 0.001504 0.001377 0.82032 0.24730 0.002881 a
(1.5152) (2.2206)* (2.9729)**
Notes: “N(Buy)” and “N(Sell)” are the number of buy and sell signals. “(buy)” and “(sell)” are the standard deviations of buy and sell periods. “Buy>0”
and “Sell>0” are the fractions of buy and sell returns greater than zero. Numbers in parentheses are t-ratios testing the significance of the mean buy return
from the unconditional mean, the mean sell return from the unconditional mean and the buy–sell spread from zero. Numbers marked with *(**) are
significant at the 5%(1%) level. Buy–sell returns marked with a give a higher buy–sell spread than the SETAR(200) and MA (50) rules.
An immediate implication of our finding is that investors are able to improve the perfor-
mance of their portfolios by combining the existing profitable trading rules. Note that the
combined rule has synergy in both China’s and the U.S. market, thus our result applies to
both developed and emerging stock markets with different degrees of market efficiency.
Note also that our result is still consistent with the EMH since our combined strategy is
based on trading rules that are already profitable. If a market is very efficient, and no
trading rules can beat it, we do not suggest that a profitable trading rule can be constructed
by combining unprofitable rules to an efficient market inefficient.
Acknowledgment
We would like to thank Carrella Ernesto and Lumpkin Mcspadden for their able research
assistance.
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1350019-17
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How to make a proﬁtable trading strategy more proﬁtable?

Article in The Singapore Economic Review · September 2013

Terence Tai Leung Chong

corporate governance View project

Special Issue "Stock Market Volatility Modelling and Forecasting":

The user has requested enhancement of the downloaded file.

HOW TO MAKE A PROFITABLE TRADING STRATEGY

TERENCE TAI-LEUNG CHONG*

Shatin, N. T., Hong Kong

Department of International Economics and Trade

Published 28 August 2013

JEL Classifications: C22, G10, G12

been growing interest in nonlinear trading rules (Fernández-Rodríguez et al., 2003;

2.2. Moving average (MA)

2.3. Test statistic

where is the unconditional daily mean and 2 is the unconditional variance.

3. Data and Results

statistically significant at the 1% level.

Table 1. Summary Statistics for Daily Returns-Full Sample

Table 2. Parameter Estimates for the SETAR Models

SETAR parameter estimates

Table 3. Empirical Results for the SETAR(200) Rule

Table 4. Empirical Results for the MA(50) Trading Rule

The random-walk specification is consistent with the Efficient Market Hypothesis

4.1. Random-walk model

Table 5. Parameter Estimates for the GARCH-M Model

Table 6. Random-walk Bootstrap Simulation Tests for 500 Replications: SETAR(200)

Result Buy (Buy) t-stat(Buy) Sell (Sell) t-stat(Sell) Buy–Sell t-stat(Buy–Sell)

0.0340 0.5500 0.0140 0.9040 0.9180 0.9700 0.0200 0.0140

Table 7. Random-walk Bootstrap Simulation Tests for 500 Replications: MA(50)

Result Buy (Buy) t-stat(Buy) Sell (Sell) t-stat(Sell) Buy–Sell t-stat(Buy–Sell)

Table 8. GARCH-M Bootstrap Simulation Tests for 500 Replications: SETAR(200)

Result Buy (Buy) t-stat(Buy) Sell (Sell) t-stat(Sell) Buy–Sell t-stat(Buy–Sell)

0.0460 0.5100 0.0080 0.8560 0.9180 0.9600 0.0260 0.0180

4.2. GARCH-M model

Table 9. GARCH-M Bootstrap Simulation Tests for 500 Replications: MA(50)

Result Buy (Buy) t-stat(Buy) Sell (Sell) t-stat(Sell) Buy–Sell t-stat(Buy–Sell)

5. The Combined Strategy and Concluding Remarks

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